How to understand liquidity when it comes to NFTs

NFTs by nature are unique and short supply and yet we have overnight billion dollar businesses being built on selling joke memes and animal cartoon artwork

Let’s start with what is liquidity ?

Liquidity is a term used in the security market. It defines how easily a company can convert its assets into cash. An essential factor when it comes to the value of a company. It’s important because it allows investors to invest in a company knowing that they can quickly liquidate their shares for cash.

If the company is not liquid, investors become wary, and the company faces challenges in raising funds and thereby stops growing. So, in short, liquidity refers to the degree to which an asset or security can be bought or sold in the market without affecting the asset’s price.

Now let’s try to understand NFTs from the liquidity lens

NFT stands for Non-Fungible Token. They are blockchain assets in the form of unique tokens, just like a company’s share. NFTs generally represent the digital identity of a product, an artwork, music, or any other creation that creators decide to put on the blockchain. Their unit of transaction is the token.

So as a buyer or investor, those who buy NFTs differ from traditional retail investors in the following sense. Instead of buying a share representing the ownership percentage of a company that is off-chain, they buy a token representing the ownership percentage of a product, artwork, game or music on-chain.

But NFTs are not just tokens. They have elements of community and culture intertwined within them. It is the community that creates the value or scarcity for an NFT (or any asset). At the same time, the concept of ownership is a cultural statement as much as a driver for wealth accumulation.

However, to accelerate wealth and create cultural exclusivity, there needs to be a volume of trading in a centralised market where every buyer can buy any NFT using a standardised currency.

But that is not always the case.

For all NFTs, the primary trading market is within the blockchain network, where they are minted. Within that blockchain network, people trade these NFTs using that platform’s currency(coin). Liquidity of the NFT is the ease with which it can be bought or sold within that network for cash in return.

But in many cases, trades are made, not for cash but swaps. Buyers swap a token for another token or fractions of tokens representing another NFT on the same blockchain. This causes a problem in the definition of liquidity since there is no cash transaction.

Another challenge is in the inherent liquidity of the network.

Network liquidity depends on the size of the network, the number of transactions taking place, and the liquidity inherent to that system. This is a huge factor in determining the price of NFTs since the price stability of NFTs (or any asset) increases as their liquidity increases. Now, if an NFT is confined to just one blockchain, there can only be a limited number of transactions, which by theory, goes against increasing the price of the NFT or improving the price stability.

This is a problem for real-world mass adoption of NFTs as an asset for trading. And because of all the above reasons, currently, there is no single accepted definition of liquidity for non-fungible tokens. It is hard to define liquidity for NFTs since different assets have different liquidity depending on an individual user’s needs. Some people might want to swap it for another NFT. Some might want to stake it in a liquidity pool (DeFi), and some might like to exchange it for cash.

What does the real-world retail investor want?

Blockchain and NFTs have not yet found real-world mass acceptance even though there is a ton of innovation around them. For the everyday retail investor, the needs are simple. S/he needs a liquid market with high trading volume where s/he can quickly liquidate assets in exchange for cash. High trading volume prevents market manipulation and allows sellers to find buyers easily and vice versa without worrying about increasingly volatile pricing.

For retail investors, this security is essential.

Easy liquidity is thereby an essential factor for NFTs to gain widespread use cases and mass cultural adoption. However, liquidity depends on the NFTs supply and demand, which is what creates price stability.

What makes it different, though, is that unlike a stock or a bond, NFTs have another way of being tradable where it is more like a unique crypto asset being transferred directly between two users.

Increasing the supply of a uniquely tradeable asset between two users within a specific blockchain network is quite tricky. However, if supply cannot be increased, demand for the NFT will drop, and pricing will hit a ceiling.

This is not a good market dynamic for investors to invest their money.

So how is crypto solving for it?

One of the primary use cases that led to NFTs becoming popular was providing a solution for “platform risk.” Buy an in-game add-on for a video game, and your purchase would exist only on the publisher platform. Files would be hosted on company servers until the game was retired, at which point everything would vanish into the Ether.

By contrast, NFTs promised to interact directly with a blockchain, which meant that each computer in the network would retain a complete record of all transactions. No single company would be responsible for storing the data, the thinking being that if one front-end interface crumbled, another would step in.

Ethereum was the blockchain that led on this promise and the impact shows.

As of date (per data shared by Moonstream) 80% of all NFTs are on Ethereum. This creates market stability (and also monopoly) since, as an investor, you only need to be on Ethereum, buy on Ethereum and sell on Ethereum. It has been a leading factor in the explosion of public interest around Ethereum (one look at the price of Ether will assure you of that).

But every day, new blockchain platforms are opening up, and NFTs are being created on those. Here is an example where world-famous DJ Deadmau5 is creating an album drop on the Solana Blockchain.

Now, if you want to own a part of that, you need to buy some Solana.

Hence, theoretically, there can be a future world where multiple blockchains have multiple kinds of NFTs, and as an investor, you might want to invest in all/any of them.

But the pricing structure and blockchain guidelines of Ethereum are different from that of Solana. In both, you have to convert your Fiat investment into the coin of that specific blockchain without a standard coefficient of conversion. Imagine this non-standardised currency conversion and blockchain interoperability protocols compounded across hundreds of blockchains and thousands of NFTs minted on them. Tokens don’t really follow a uniform pricing structure. They actually behave like currencies of sovereign countries. Each cryptocurrency has a different conversion rate to Fiat money and no systemic governance around inflation or deflation.

This could make it slightly tricky to quickly liquidate your NFT assets for cash using a standardised value or the ability to liquidate and create projections around your entire portfolio.

In the crypto world, a token’s liquidity is dependent on the market cap, market volume and market depth of the blockchain it’s minted on. Therefore for NFTs, liquidity is the number of units(token) that can be traded. However, since NFTs have a fixed supply, for more units to be traded, there is a need for secondary marketplaces where supply is not fixed. These would allow for more tokens to be traded, which would increase the price of a token and make the NFT much more stable as a trading asset.

This is where crypto has brought the concept of secondary marketplaces into play.

Third-party services, listing aggregators and secondary marketplaces

The concept of NFT exchanges or listing aggregators came into existence because these could be made into marketplaces where supply would not be fixed and interoperability would not be an issue, thereby increasing liquidity, pricing, and trading volume.

To give you an example, let’s consider OpenSea, which acts as a listing aggregator. You cannot trade SuperRare NFTs on Foundation, or Foundation NFTs on SuperRare, but you can sell both on OpenSea. So while platforms like Foundation and SuperRare support trades only with specific, curated NFT collections, OpenSea supports a much more comprehensive range of projects.

It makes the OpeaSea network liquid and perfect for trade. It shows in the numbers as well. According to DappRadar OpenSea has done over $2B in trading volume in the last 30 days.

And it doesn’t end here. Today, liquidity in NFTs means the ability to quickly trade an NFT for cash, whether via a third-party service like Rarebits or Ethplorer, or through exchanges like OpenSea, which solves the interoperability problem by creating what it calls the Shared Storefront Smart Contract.

Here is a listing of the top marketplaces according to DappRadar

These marketplaces are how crypto is solving for the liquidity in NFTs, and with major centralised crypto exchanges like Coinbase and FTX announcing their own NFT marketplaces recently, it will no doubt bring more moderation and more investment into the market. Add to it other marketplaces like Foundation, KnownOrigin, Nifty Gateway, Rarible, SuperRare and Zora; it becomes increasingly apparent that there is a ton of focus in the crypto developer sphere around facilitating trade by creating more liquidity around NFTs.

Key takes

While I understand a bit more about liquidity and NFTs than I used to, some concepts are still unclear to me after spending a few days burrowing down the NFT rabbit hole. But that’s ok. That was the whole point of starting on this learning journey.

Here is where I am still not clear.

Investing in art as an asset has been there for a while and is a profitable trading option. You do not need crypto or NFT for that, so I am still struggling to understand the real-world use case that NFTs are solving for artists, to make them more successful by opening up newer markets and newer buyers.

Yes, in theory, one can own a portion of the Monalisa if it was made into an NFT, but to date, only a handful of classic masterpieces have been converted to NFTs. Experiments around this have met with widespread criticism. Also, I don’t know about others, but I have no intention of owning a portion of the Monalisa. There is only one Monalisa, and the only way I would love to own a Monalisa is if I could have the original hung in my house, but that too would be not very smart because I would not be able to secure or sell it easily.

Millions of people would lose out on the opportunity to see it in person. The concept of converting my home into a museum and charging tickets for people to come and see one Monalisa does not seem like a good business idea.

So bragging rights won’t work that well.

(Caveat: Yes I do agree that many people might want to own a piece of the Monalisa through tokens as an investment option for driving profit)

If I had the money, I would love to trade in original artworks from new artists, but in reality, the bulk of trading is happening around joke memes and weird graphic artworks around apes and penguins and some very random stuff. Not saying that these are not cool; I just don’t see millions of people travelling half the world to see a picture of Bored Apes just yet (something millions of tourists do every year to see masterpieces in museums across the globe) Yes you can see all the museums and artworks of the world on a blockchain, but we can already do that on Google Arts.

While we are at it, why don’t we take a look at the famous Bored Apes Yacht Club, one of the most famous and highly traded NFT collections ever. The website itself is not on a crypto stack. They have on sale 10,000 cartoon ape images which allow early adopters in crypto, gain access to a virtual club.

So what does this virtual club give you access to?

BAYC is a collection of 10,000 Bored Ape NFTs — unique digital collectibles living on the Ethereum blockchain. Your Bored Ape doubles as your Yacht Club membership card, and grants access to members-only benefits, the first of which is access to THE BATHROOM, a collaborative graffiti board. Future areas and perks can be unlocked by the community through roadmap activation.

Make of that what you will, and yet … Christie’s is auctioning them. In less than a year, they are a billion dollar business

Maybe at some level, this is just a cultural zeitgeist. Maybe at the other extreme, people are not interested in owning apes. Perhaps they are just interested in flipping them overnight at 5x the price they were brought for.

Super influencers and early adopters have already created a hype train around NFTs. FOMO is real.

The feeling that everyone is getting rich overnight, but me, is real.

So, what if the real current craze is not around creating newer paradigms in art and artistry but in the opportunity of riding an early trend. A story of community leverage. Of an irreverent internet punk culture sticking a thumbs-down to traditional forms of finance that have mostly favoured the uber-rich for decades.

Maybe the APE symbolises irreverence. Not the art.

Isn’t that how most new tech consolidates? Think of the innovation and the cultural impact of open source and then the consolidation of services under closed source — billions of Microsoft PCs and iPhones.

I do not have the necessary knowledge or skill to future predict, but time will probably tell.

What I do have, is some data which says that the volume of trading in NFTs is mostly happening as a speculative asset that can turn an exponential profit quickly. Most of these investments are being made by people with liquidity who can afford to play the game and not get burnt. They are just investing their money into a market which, due to volatility and lack of regulation, can flip it 5x in a double short time than the average 12–15 % return in traditional stock markets.

Nothing wrong here, though. If there is indeed such an opportunity, why would anyone not take it? It is mostly happening as innovators try new things with early adopters to figure out what sticks.

Right now, it’s all games, but then games become solutions to real-world problems.

Take a look at the chart below (from Messari) and see how some popular NFTs have changed in value (YTD)

For now, though, it would seem like speculation and profitability are driving the NFT craze, not some artistic renaissance. I may be wrong, but I haven’t yet read glowing reviews of NFT art by renowned art critics’.

I do believe that this will change in time.

At least, I sincerely hope it does because that is the real promise of crypto. What makes it so seductive. The underlying concept of NFT can change the market dynamics for everyday artists, creators and gamers in unlimited ways. It has the power to unlock new buyers, weed out intermediaries, drive incredible transparency, promote REAL talent based on meritocracy and foster great communities.

But that’s not exactly what’s happening now in its very early days.

Be mindful as well, that none of this is impossible with what we already have. We can, if we want to, create our own communities. Every industry “influencer” writing about web3.0 is using a web2.0 platform to do so. They are influencing the communities that these web2.0 platforms already provide. I am currently writing this article on a web 2.0 newsletter platform known for its community feature. After this, I will post it on Twitter which is again web 2.0.

What I want to know is what is web 3.0’s Twitter, Substack or Discord? How many people are using it? What problems of network and communication are they solving?

Technology has the power of driving the greater good when used in the right way. I am convinced that we will see unparalleled innovation in the crypto space in the next decade that will answer all these questions.

The fundamental core premise is extremely powerful.

I am also confident that as these concepts consolidate and become more popular, they will start getting more eyeballs from securities and tax offices and become far less volatile and far more predictable. By then, crypto will be solving far-ranging pertinent real-world problems. In the process, the industry will update rules, create regulations and invoke standards.

The blockchain won’t lie as long as contributors to the blockchain do not lie.

About Me:

In my day job I drive product marketing and growth @ Google

For the next few months I will use this publication on Medium titled Metapherse to curate my experiences of learning web 3.0 in the open.Follow me on twitter @hackrlife or on my substack on all things Web 3.0 here.